class: center, middle, inverse, title-slide .title[ # Principles of Microeconomics ] .author[ ### ECO 2306 ] .date[ ### <em>Fall 2022</em> ] --- class: center, middle, inverse # Chapter 5: Externalities, Environmental Policy, and Public Goods --- ## Introduction to Externalities .panelset[ .panel[.panel-name[Overview] - **Externality**: - A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service - e.g. pollution - side-effect ] .panel[.panel-name[Effect] - Interfere with economic efficiency - Private vs. social cost - Private cost: cost borne by the producer of a good or service - Social cost: total cost of producing a good or service,including both the private cost and any external cost - Private vs. social benefit - Private benefit: benefit received by the consumer of a good or service - Social benefit: total benefit from consuming a good or service, including both the private benefit and any external benefit - When the total cost of production is greater than the private cost, then there is a negative externality - When the total benefit of consumption is greater than the private benefit of consumption, then there is a positive externality ] ] --- ## Negative Externalities .panelset[ .panel[.panel-name[Energy Production] - Background - Consider the market for electricity. It consists of: - Sellers, who face increasing marginal costs to produce electricity - Buyers, who face decreasing marginal benefits of additional electricity - The actions of these groups generate market supply and demand curves for electricity. ] .panel[.panel-name[Costs of Electricity Production] - When firms produce electricity, they bear certain costs of production: - Buildings - Equipment - Fuel - Labor, etc. - Those firms make their decisions about how much to produce based on these private costs. - But because of pollution - the social cost is higher - including both the private cost and any external cost. ] .panel[.panel-name[Effect on Efficiency] <img src="data:image/png;base64,#images/fig_5_1a.png" width="50%" style="display: block; margin: auto;" /> ] .panel[.panel-name[-] <img src="data:image/png;base64,#images/fig_5_1b.png" width="50%" style="display: block; margin: auto;" /> ] ] --- ## Positive Externalities .panelset[ .panel[.panel-name[Positive vs. Negative] Pollution is an example of a negative externality in production. - Negative externalities might result from consumption. - Example: cigarette smoke. Externalities might also be positive when the private benefit (the benefit received by the consumer of a good or service) is less than the social benefit (the total benefit from consuming a good or service, including both the private benefit and any external benefit). - Example: college education ] .panel[.panel-name[Application] <img src="data:image/png;base64,#images/fig_5_2.png" width="50%" style="display: block; margin: auto;" /> ] ] --- ## Market Failure .panelset[ .panel[.panel-name[Externalities] - Externalities => inefficient market outcomes - Overproduction or underproduction - => deadweight loss - **Market failure**: - a situation in which the market fails to produce the efficient level of output - The larger the externality, the greater the likelihood of DWL - DWL is how we measure the extent of market failure ] .panel[.panel-name[Cause] - **Property rights** - the rights individuals/business have to the exclusive use of their property, including the right to buy/sell it - 3 characterisitcs 1. *exclusivity* 2. *enforceability* 3. *transferability* - Externalities can be the result of inability to assign/enforce property rights across these 3 characteristics ] .panel[.panel-name[Solutions] - Broadly 2 solutions - Private - Public - Private - Farmer and paper mill share a stream - Is zero pollution efficient? - Public - Farmer and paper mill share a stream - Clean Air Act of 1970 ] .panel[.panel-name[Clean Air Act] - Clean Air Act in 1970 was a public solution - Led to reduction of total emissions of carbon monoxide, nitrogen oxides, and other pollutants - In the two years following the Clean Air Act, there was a sharp reduction in air pollution and also infant mortality - Benefits from the reduction in pollution: - In 1972, 1,300 fewer infants and 9,900 fewer fetuses died - Healthier children born in the previously most polluted counties earned ~$4,300 more as adults - Marginal cost/benefit considerations - When pollution is very high, then the marginal benefit of reducing it is also high - When pollution is very high, the marginal cost of reducing it is low ] .panel[.panel-name[Cost/Benefits] <img src="data:image/png;base64,#images/fig_5_3.png" width="40%" style="display: block; margin: auto;" /> <!--  --> ] .panel[.panel-name[Cost/Benefits] <img src="data:image/png;base64,#images/fig_5_4.png" width="35%" style="display: block; margin: auto;" /> <!--  --> ] ] --- ## Solutions: Public vs. Private .panelset[ .panel[.panel-name[Private Solutions] - Private solutions reached via bargaining - Producing electricity example - We assumed the damages are borne by the consumers and the costs of cleanup by the firm? - What happens if the firm has the right to use the atmosphere? - What would they negotiate? - How much would consumers be willing to pay? - Example: the Fable of the Bees - James Meade (1952) - Steven Cheung (1973) ] .panel[.panel-name[Coase Theorem] - Private parties can solve the externality problem through private bargaining, provided: 1. Property rights are assigned and enforceable, and 2. Transactions costs are low - **Transaction costs**: The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services - Does it matter who is assigned the property rights? (Think about the paper mill and the farmer example) ] .panel[.panel-name[Public Solutions] .pull-left[ - When private solutions to externalities are not feasible, how should the government intervene? - Chapter 4: taxes => DWL by shiftng production away from efficient level - Externalities do the same thing - What if we were able to use taxes to shift the incentives to get us back to efficiency? - Example: negative externality ] .pull-right[] ] .panel[.panel-name[Pigouvian Taxes] - A.C. Pigou was the first to analyze market failure systematically - Pigou argued that to deal with a negative externality in production, the government should impose a tax equal to the cost of the externality - Called appropriately a Pigouvian tax - Pigouvian taxes force producers to internalize the costs of the externality, which in turn leads them to choose the optimal level as a course of choosing their own private optimal choice - Property rights, if we could extend them, would also internalize the costs of the externality to the manufacturer ] .panel[.panel-name[Discussion] - Why are Pigouvian taxes popular with economists? - Name some of the externalities associated with alcohol, cigarettes and soda - Should we tax them? - How much should we tax them? - What information do we need to know to answer this question? - Can we rely on private remedies or are there transaction costs? - What are other considerations besides economic efficiency? ] .panel[.panel-name[Alternatives] - Traditional solution - **command and control**: A policy that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices - Example: coal burning electric plants would be required to install specific scrubbers for reducing pollutants at each plant - Problem: What if firms have very different costs of reducing pollution? - Consider Ford and GM - Ford can reduce pollution in cars cheaply - GM costs a lot to reduce pollution - What should the policy be to make it efficient and fair? - **Cap-and-trade**: market-based policies used to allocate the pollution reduction onto those firms who had a comparative advantage at reducing pollution ] .panel[.panel-name[Sulfur Dioxide I] - The government establishes an allowable amount of emissions. - Emissions permits are distributed - Firms can trade emissions permits - Firms with high costs of reducing pollution will buy permits from firms with low costs of reducing pollution, ensuring that pollution is reduced at the lowest possible cost - Hence, the market is used to achieve efficient pollution reduction - In 1990, Congress enacted a cap-and-trade system for sulfur dioxide emission - Used to reduce sulfur dioxide emissions - Federal government gave allowances to utilities equal to the total target amount of sulfur dioxide emissions - Utilities were then free to buy and sell the allowances - Payment was unavoidable -- either you paid to reduce the pollution, or you paid someone else to reduce it for you ] .panel[.panel-name[Sulfur Dioxide II] - How'd it do? - Improvements in pollution reduction technology resulted, with the cost of compliance ending up almost 90 percent less than firms initially estimated. - This program was very effective, with benefits at least 25 times the cost of implementing the program. - By 2013, the program had effectively ended. Why? - Further emissions reductions were needed; President Bush attempted to lower the cap during the 2000s, but Congress resisted. - As a result, the E P A decided to return to a command-and-control approach in order to achieve the reductions. - While cap-and-trade appears to be very effective, any policy needs political backing to have a chance at success - Critique of cap-and-trade: "license to pollute" ] ] --- ## Public Goods .pull-left[ <!-- - Some goods naturally have externalities --> <!-- - some approach efficiency better than others --> <!-- - this is due to whether consumption is rival and/or excludeable --> - **Rivalry** is the situation that occurs when one person consuming a unit of a good means no one else can consume it - **Excludability** is the situation in which anyone who does not pay for a good cannot consume it - **Private goods** - goods that are both rival and excludable - Markets tend to be good at providing efficient levels of private goods. Why? - **Public goods** - both nonrival and nonexcludable - Markets are not so good at providing efficient levels of the other types of goods. Why? - **Free riding** is benefiting from a good without paying for it - **Common resources** are goods that are rival but not excludable ] .pull-right[] --- ## Constructing Market Demand - Constructing market demand curve for private good: sum horizontally (show on board) - Constructing market demand curve for public good: sum vertically (show on board) - The optimal quantity of a public good is then the intersection of the demand curve with the supply curve - **Tragedy of the commons** is the tendency for a common resource to be overused - What is the source of the tragedy of the commons? - How do we solve it? ---